Posted by Robert on September 20, 2010
A reader asked, in the comments on a previous post, why I don’t use the “conventional wisdom” of a safe withdrawal rate of 4%. I have given a lot of thought to producing income from investments, which I’ll lay out below. I’m going to ignore rental income from real estate investments, because I view that as a part-time job. People who do it, already understand it.
The safest, most secure option is an annuity. This is practically the same as buying a portfolio (or ladder) of bonds. The principal is guaranteed, the payments are guaranteed, and it’s set for life. An additional benefit, if the money is non-registered (outside of an RRSP), the taxation is smoothed over the life of the contract, producing a greater after-tax income than a portfolio of bonds. The income includes a return of capital, so that the income is guaranteed to last the rest of your life, then it’s all gone at death. This is perfect for someone who wants to spend their last penny the day they die. The last time I looked, the income represented about a 5% payout.
Another option is to buy a portfolio of growth stocks, then sell a portion each year to produce income in retirement. The first problem is how much can we sell without drawing down capital? Because the order of returns matters, only a low withdrawal rate is sustainable. Backtesting has shown that 5% will work about 75% of the time, and a 4% withdrawal rate is safe over 90% of the time. The second problem is demographic. If a large cohort (baby-boomers) all retire around the same time, who’s going to buy the shares they are selling? Possibly their children and possibly foreigners, but there is a chance for a supply/demand imbalance. The benefit of this strategy is that the capital is still available, either for lump-sum needs or to bequeath at death.
A hybrid approach is the Guaranteed Minimum Withdrawal Benefit (GMWB) offered by life insurance companies. Like an annuity, there is a minimum guaranteed payment for life. Like stocks, there is a chance of higher payments if the portfolio grows and a chance some capital could be left at death. In practice, the income offered is 5% and the fees are often over 3%, meaning that if the stock market doesn’t return over 8% consistently (again, the order of returns matters), there won’t be any increase or remaining capital. The retiree needs to choose whether or not the guarantees are worth the cost.
Another modification to the “all capital gains” method is to use “buckets.” In this scenario, a retiree would keep three to five years worth of income in cash or, better, government bonds. If the stock market turns down, the bonds are sold to fund retirement income. Later, when the stock market grows, profits can be used to fund the bond “bucket”. This adds some safety at the cost of lower returns on bonds than on stocks, but market can take longer than five years from crash to full recovery. It’s an improvement over all capital gains, but it’s not as safe as all guarantees.
The final option is to use dividends from stocks. The yield that can be achieved is probably 4% – 5% currently, but it depends on the market level. The risk is that dividends are not guaranteed and could be skipped or cut. The benefit is that there is also a possibility of capital gains to fall back on. Sometimes the market favours large, dividend-paying companies (and the current environment seems to be one of those times), and sometimes those companies fall from favour (such as the Nifty Fifty). Nothing is foolproof.
Many people will only use investment income to supplement a government pension (eg. CPP) and benefits (eg OAS) and possibly a company pension. In this case, guarantees are in place and are less necessary for income from investments. The approach that’s right for any given individual depends on the level of income required, the various sources of income in place and the degree of guarantees they need to feel comfortable. But in each of the above examples, 4% – 5% seems to be about the most income a retiree (who is never planning to return to work) can expect.
On a personal note, I’m happy to plan using the total amount of income I am currently receiving from investments. That’s partly because I bought during the market crash, when yields were high because share prices had fallen precipitously, and partly because I always plan to earn income through some form of work.
Are there other options for income from investments? Which ones do you feel most comfortable with?